Year: 2011

Failure and Compliance

The theme of the April edition of the Harvard Business Review is “Failure.” That’s a scary term in the world of compliance. Generally, that means you’ve got government regulators or enforcement personnel sitting in your offices. And they are not happy. Failure and compliance can mean disciplinary action, fines, or jail time.

But you can learn from failures. You can especially learn from others’ failures.

Ethical Breakdowns by Max H. Bazerman and Ann E. Tenbrunsel takes an insightful look at ethical breakdowns and comes up with five barriers to an ethical organization. (Sorry, you need a subscription to read the entire HBR article.)

  • Ill-conceived goals
  • Motivated blindness
  • Indirect blindness
  • Slippery slope
  • Overhauling outcomes

An ill-conceived goal is the classic failure seen in sales targets, revenue projections, and stock price targets. If you give mechanics a sales goal of $147 hour they can very easily lapse into fixing things that were not broken rather than being more efficient. Sears encountered this problem in the 1990s.

The authors lump a few things into the motivated blindness category, but most notably included are conflicts of interest. They use the failure of rating agencies during the financial collapse as one example. Since the rating agencies are paid by the issuer instead of the buyer of securities, they have a misalignment of motivation. They end up serving the one who pays them, leading to lax ratings and competition for business. That means they may have rated something higher than they should have. (That’s a big understatement.)

Indirect blindness is when third parties are involved. What caught my eye was an experiment examining perceptions of an increase in the cost of a pharmaceutical drug. In the first scenario, the drug company raises the price from $3 to $9. In the second scenario, the drug company sells the rights to a smaller company who then increases the price to $15. The first scenario was judged more harshly, even though it resulted in a lesser price.

We’ve all been concerned about the slippery slope. Little lapses lead to a culture of lapses, eventually leading a big failure. The authors present some interesting research showing how this works and that it is a real problem. From a compliance perspective, they focus on auditors and how good accountants can do bad audits.

The final category is the one I found the most intriguing: overvaluing outcomes. The author’s research showed an inclination to judge actions based on outcomes rather than the behavior. One example is a research failure.

In the scenario A, a researcher pulls four subjects back into the results after they were removed for technicalities. However, the researcher thinks their data is appropriate. When adding them back in, the results shift and allows the drug to go to market. Unfortunately, the drug ends up killing six people and is pulled from the shelves.

In scenario B, a researcher makes up four more data points for how he believes subjects are likely to behave. The drug goes to market, becomes profitable and effective.

The participants in the author’s experiment judged the researcher in scenario A much more critically than the researcher in scenario B. The problem is that the person B had the bigger ethical lapse and worse behavior. It’s just that the outcome, largely by luck, was worse in A than B.

They extrapolate the findings to the situation where a manager is overlooking ethical behaviors when outcomes are good and unconsciously helping to undermine the ethical culture of an organization.

The Monstrous Size of Dodd-Frank

“What is 20 times taller than the Statue of Liberty, 15 times longer than “Moby Dick” and would take the average reader more than a month to read, even if you hunkered down with it for 40 hours a week?”

If you’ve been Dodd-Frank’ed, you know the answer.

The last round of financial overhaul was the Sarbanes-Oxley Act that came out of the Enron scandal. SOx weighs in at 66 pages. Dodd-Frank eats that for breakfast; It’s in heavyweight class at 849 pages.

That is just the legislation. Dodd-Frank put a big burden on financial regulators to work out the details to implement their vision (as myopic as it may be at times).

“In addition to the 30 rule-making procedures that already have missed the deadline set by Congress, 145 are supposed to be completed by year end…. Officials at the SEC, on the hook for more Dodd-Frank-related regulations than any other U.S. agency, have finished six rules, proposed 28 additional rules, missed deadlines on 11—and still have 50 to go, on which they have yet to issue any proposals.”

So far the regulatory “process has produced more than three million words in the Federal Register—or more than 3,500 11-inch-high pages.” And almost 2/3 of the rules required by Dodd-Frank have not even been proposed.

Congressman Barney Frank thinks missing the deadlines is no a big deal. “There is no penalty for not meeting the deadline,” Mr. Frank said during a webinar sponsored by the National LGBT Bar Association. “There’s no gun at their heads. Nobody gets fired.”

Sources:

Massachusetts Is Looking to Dodd-Frank Investment Advisers and Fund Managers

Just to keep you on your toes if you have less than $150 million under management, states are now filling in the gaps left by Dodd-Frank. If you are under that threshold, you lose the ability to register with SEC and now have to look to at being regulated at the state level.

Massachusetts used to have a very broad exemption if your clients were all “institutional buyers.”

An investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933 (17 CFR 230.501(a)) each of whom has invested a minimum of $50,000.

For a private fund manager, this was a great exemption since their investors would need to be accredited investors. As long they kept capital commitments at a minimum of $50, 000 they could usually take advantage of this exemption.

The Massachusetts Secretary of State has proposed removing this exemption as well as cleaning up other aspects of investment adviser/fund manager regulation to get ready for Dodd-Frank.

The proposal would also create new Massachusetts registration exemptions for advisers whose only clients are “venture capital funds” or funds excluded from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act. As you might expect, the term “venture capital fund” would be defined by reference to the SEC’s definition of the term. The SEC has proposed a draft definition of venture capital fund, but not yet finalized it.

What is abundantly clear is that the SEC has run out of time it trying to meet the July 21, 2011 deadline in Dodd-Frank. It’s time to raise the white flag and move the deadline. Since the SEC has not yet finalized the rules, regulated parties would have no time to understand the rules and get changes in place by July 21. Given that thousands of advisers are being kicked out of SC registration and over to state registration, the states do not have the rules in place to deal with the regulatory changes.

Sources:

 

Employment Opportunity – Senior Compliance Role

I occasionally get calls from people looking to hire compliance personnel. Here is the latest:

  • Private Equity firm looking to expand its compliance team
  • Senior compliance role reporting to the CCO
  • Company is a prominent PE firm based in TX with a large office in San Francisco
  • Knowledge of Investment Advisers Act essential
  • Experience reviewing marketing material and interacting with investor relations and fund raising required
  • Firm has a small compliance team so it is expected that this person will be willing to take on a variety of responsibilities
  • JD not required
  • Relocation available

If you are interested, you can drop me a note on the Compliance Building hotline: [email protected].

Compliance Bits and Pieces for April 29

Here are some recent compliance-related stories that caught my eye:

SFO GC resigns: SFO future cast into further doubt in The Bribery Act .com

We’re delighted to congratulate Vivian Robinson QC on his reported move today from the SFO to join a US law firm, Richmond Virginia headquartered McGuire Woods, in the near future. We’ve enjoyed working together with Vivian over recent months and look forward to doing so during the remainder of his time at the SFO.

Vivian’s move places in the spotlight once again the current uncertainty surrounding the future of the SFO.

Examining Bernie Madoff, ‘The Wizard Of Lies’ on NPR’s Fresh Air

The first journalist to interview Bernie Madoff after the money manager was sentenced to 150 years in prison says she was struck that Madoff hadn’t fundamentally changed.

Even behind bars, says New York Times financial writer Diana Henriques, Madoff was a “fluent liar.”

“The magic of his personality is how easy it is to believe him — almost how much you want to believe him,” she tells Fresh Air’s Terry Gross. “For example, he assured me in that first interview — and in emails subsequently that we exchanged — that he wasn’t going to talk to other writers. … Of course, it wasn’t true, he was talking to others. It was all a lie.”

Whistleblower Rules May Not Be Ready Until Summer by Joe Palazzolo in WSJ.com’s Corruption Currents

After missing an April deadline, the Securities and Exchange Commission said it now expects to finalize rules for its whistleblower program by July, reports Dow Jones’ Jessica Holzer. Congress had given the SEC until April 21 to write rules for the program, which was created in the Dodd-Frank law nine months ago. The commission plans to adopt rules sometime between now and the end of July, according to a revised schedule on the agency’s website.

Risk Disclosures and Form ADV Part 2 for Fund Managers

If you’re a fund manager getting ready to register because you’ve been Dodd-Frank’ed, then you are likely in the middle of drafting Part 2 of Form ADV, the brochure. One item that caused my to pause was the risk factor requirements in Item 8.

8.B:  For each significant investment strategy or method of analysis you use, explain the material risks involved. If the method of analysis or strategy involves significant or unusual risks, discuss these risks in detail. If your primary strategy involves frequent trading of securities, explain how frequent trading can affect investment performance, particularly through increased brokerage and other transaction costs and taxes.

Fund sponsors spend a great deal of time, money, and energy drafting risk factors for their fund’s private placement offering memorandum.

Do you need to duplicate those risk factors in response to 8B or can you ignore them?

The SEC staff answered that question about Part 2 of Form ADV.

Question II. 4

Q: Item 8.B of Part 2A requires an adviser to explain the material risks for each significant investment strategy or method of analysis the adviser uses. Does Item 8.B require an adviser that uses pooled investment vehicles as a significant investment strategy or method of analysis to duplicate the risk disclosures contained in a prospectus or other offering document for the pooled investment vehicle?

A: An adviser may satisfy the requirement of Item 8.B by providing a brief explanation of the material risks for each strategy and referring clients to the prospectus, offering memoranda, or other documents that a client participating in the pool will or has received that set out a more detailed discussion of risks. (Posted March 18, 2011)

Sources:

The Case for Executive Assistants

Why would you pay managers big salaries and then ask them to make their own hotel reservations?

Since it’s Administrative Professionals Day, a story in this month’s Harvard Business Review caught my eye: The Case for Executive Assistants. (Now looking at the Administrative Professionals’ website, I see it has grown from being mere a day to become an entire week.)

Technologies like e-mail, voice mail, mobile devices, and online calendars have allowed managers at all levels to operate with a greater degree of self-sufficiency. At the same time, companies have faced enormous pressure to cut costs, reduce head count, and flatten organizational structures. As a result, the numbers of assistants at lower corporate levels have dwindled in most corporations. That’s unfortunate, because effective assistants can make enormous contributions to productivity at all levels of the organization.

The author does some simple math to justify the cost of administrative assistants.

Consider a senior executive whose total compensation package is $1 million annually, who works with an assistant who earns $80,000. For the organization to break even, the assistant must make the executive 8% more productive than he or she would be working solo—for instance, the assistant needs to save the executive roughly five hours in a 60-hour workweek.

Of course, lots of the burden for getting that productivity boost lies with the executive/manager. You need to delegate wisely.

It’s a great, short article and timely. Unlike most content from the Harvard Business review, this article is available for free. (At least for today.)

Turning Your PowerPoint into an Advertisement

Once a fund manager is registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative. That means public presentations could be considered an advertisement.

First I want to look back at the definition of an “advertisement” for purposes of the rule. An advertisement for purposes of the rule 206(4)-1 is:

“[A]ny notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”

In meeting with potential investors, invariably, someone will pull out a Powerpoint presentation to discuss the fund manager, their past performance, and future business plan. In looking at the definition of advertisement, a purely oral presentation would not be an advertisement. One the projector lights up, the presentation starts moving into the realm of an advertisement.

The final straw is leaving a copy of the presentation behind. Now the presentation is clearly a “written communication.”

And don’t forget about the requirements of Regulation D regarding advertising and disclosure requirements for privately-offered securities.

Fees and Performance Results for Advisers and Fund Managers

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier. The second item in the advertising rule is a prohibition on using past performance in an advertisement, subject to some limitations. I also wrote about that last week.

One of the controversial standards when using performance results is that they must be shown net of fees.

In a 1986 No Action Letter to Clover Management the SEC said it was their view that “Rule 206(4)-1(a)(5) prohibits an advertisement that: … (2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid; ”

Can you just include a description of your fees? No.

[B]ecause advertisements typically present adviser performance results over a number of
years, narrative disclosure of the existence and range of advisory fees, in our view, would
not be an adequate substitute for deducting advisory fees because of the compounding
effect on performance figures that occurs if advisory fees are not deducted. In our view it is
inappropriate to require a reader to calculate the compounding effect of the undeducted
expenses on the advertised performance figures. Investment Company Institute No Action Letter (1987)

But you can include gross returns, as long as they are side-by-side with net of fees results. See Association of Investment Management and Research (1996). Both the net and gross performance figures need to be presented in an equally prominent manner. The “advertisement” must contain sufficient disclosure to ensure that the performance figures are not misleading. For example, when showing a performance figure gross of fees there should be a disclaimer that the figures do not reflect the payment of investment advisory fees and other expenses.

Sources:

Compliance Bits and Pieces – Good Friday Edition

The stock markets are closed, but most banks are open. I’m taking the day off from work, but wanted to highlight a few compliance-related stories that caught my eye.

Justice is served, but more so after lunch: how food-breaks sway the decisions of judges by Ed Yong in Discover’s Not Exactly Rocket Science

There’s an old trope that says justice is “what the judge ate for breakfast”. It was coined by Jerome Frank, himself a judge, and it’s a powerful symbol of the legal realism movement. This school of thought holds that the law, being a human concoction, is subject to the same foibles, biases and imperfections that affect everything humans do. We’d love to believe that a judge’s rulings are solely based on rational decisions and written laws. In reality, they can be influenced by irrelevant things like their moods and, as Frank suggested, their breakfasts.

Chief Compliance Officers: The Evolving Picture by Michael Volkov in White Collar Defense & Compliance

In the next five years, the position of CCO will take on a new and more dynamic role in every company. With the rise of enforcement, it is inevitable that the importance of the CCO will increase in every organization. CCOs are likely to rise in organizations to a level equal to General Counsels and Chief Financial Officers.

How Do I Know If My Company Is Compliant If I Don’t Know Every Applicable Law and Regulation? by Ted Polakowski in Corporate Compliance Insights

This is one of the hardest questions to answer since you just don’t know what you don’t know. … This is because within any country, there exist – in addition to the governmental body that creates law – many regulatory agencies that are chartered with putting the rules of operation into play. Just trying to find out who those agencies are and where they list their regulations can be a daunting task in itself.

The housing boom and bust, part 2 by Russ Roberts in Cafe Hayek

Once the price of housing started rising dramatically, it became profitable to bet on the rise continuing. So a lot of people, smart and stupid, tried to ride that meteor as it shot upward. And that’s where the shadow banking system and the low interest rates come in. The shadow bankers pumped trillions into that market via all those innovative new assets (CDO’s, CDO squared etc). They use borrowed money because they could. The lenders lent the money because the government had signaled that lenders would get made whole even when the bets their loans financed were worthless.

Richard Ford on the Meaning of Work in the Wall Street Journal’s Speakeasy

Work, after all — to me, anyway — signifies something hard. And while writing novels can be (I love this word) challenging (it can also be tedious in the extreme; take forever to finish; demoralize me into granite and make me want to quit and find another line of work), it’s not ever what I’d call hard. A hard job, okay, would have to be strenuous and pressurized (writing’s almost never that way). It would have to be obdurate, never offering me a chance to let up (I can quit writing any time I want to and come back tomorrow, or never). And it would have to be skimpy on personal-spiritual rewards (I’m always trying to do what Chekhov did…change the way some reader sees the world; so big rewards are always out there). In my view, being a first-year law student at Harvard would not be hard; but being a non-partnered associate at Skadden, Arps would be. Learning to play “The Flight of the Bumble Bee” on a Sousaphone would not be hard; but working on the dashboard assembly team for the Ford-150 would most certainly be. You see what I mean. Hard is staring into one of those mind-corroding x-ray machines at LaGuardia. Or taking tolls on the Jersey Turnpike.